Today, we go to Clay Allen of Market Dynamics for more color on the same:

“It has been shown that long-term investors stay with stocks that don’t provide good performance for far too long. This seems to be such a strong tendency for many investors that considerable care must be taken to avoid this serious source of major losses in the portfolio. How does the investor guard against his own behavior that allows him to hold poorly performing stocks for far too long?”

“The investor must make a commitment to eliminating poorly performing stocks just as soon as they can be identified. The best way to identify poorly performing stocks is with a long-term chart that shows relative strength. The investor must have a very clear idea about what constitutes unacceptable performance. There must be a predetermined decision point that cannot be reached without action being taken to sell the stock.”

“It is often surprising how correct the collective judgment of the market can be when a stock starts to have performance problems. The discounting process of the market and resulting poor performance of the stock starts to reveal the onset of negative developments in the financial performance of the company long before those fundamentals is made public.”

“The onset of poor market performance is one of the best recommendations a long-term investor can make to eliminate the bad stock from a portfolio. However, it seems common for long-term investors to either overlook the poor performance or assume that it is a temporary development and believe that that better market performance will surely follow. Poor performance is euphemistically called a correction and it is essentially a denial that the stock did not go up as expected.”

“It then becomes common for the long-term investor to believe that the stocks can’t be sold because it has gone down too much. Too much relative to what? The down trend persists and the long-term investor becomes psychologically trapped in the poorly performing stock.”

“The best defense against these common difficulties is to measure the performance of each stock in the portfolio. Very clear rules can be formulated that will force the sale of a poorly performing stock while the damage is still small.”

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About Barry Ritholtz

Ritholtz has been observing capital markets with a critical eye for 20 years. With a background in math & sciences and a law school degree, he is not your typical Wall St. persona. He left Law for Finance, working as a trader, researcher and strategist before graduating to asset managementRead More...

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